Test bank accounting management 11e chapter 15 SUPPORT DEPARTMENT, COMMON COST, AND REVENUE ALLOCATIONS

Allocate support department costs using the direct, step-down, and reciprocal methods 4.. Allocate the revenues of a bundled package to the individual products in that package CHAPTER OV

CHAPTER 15

SUPPORT DEPARTMENT, COMMON COST, AND

REVENUE ALLOCATIONS LEARNING OBJECTIVES

1 Differentiate the single-rate from the dual-rate cost-allocation method

2 Understand how the uncertainty managers face is affected by the choice between budgeted and actual cost-allocation rates

3 Allocate support department costs using the direct, step-down, and reciprocal methods

4 Allocate common costs using either the stand-alone or the incremental method

5 Explain the importance of explicit agreement between contracting parties when reimbursement is based on costs incurred

6 Understand how bundling of products gives rise to revenue-allocation issues

7 Allocate the revenues of a bundled package to the individual products in that package

CHAPTER OVERVIEW

Chapter 15 continues the study of the allocation of indirect costs—on the micro/application level The concept of cost allocation was introduced in Chapter 2 in relation to a cost object A review of that information might be helpful at the beginning of the study of this chapter In Chapter 4, cost allocation becomes a focus The costing of a product or service using a normal costing system emphasizes the application of the allocation concept Again, the topic of cost allocation is studied through activity-based costing presented in Chapter 5 With the introduction of budgets and standards, cost allocation is a main subject (Chapter 8) The first lines of this chapter recognize the pervasiveness of the topic and the difficulty in finding satisfactory answers to questions about cost allocation Chapter 14 gives the purpose for which cost is allocated as the starting point in the allocation process

Three specific methods, direct, step-down, and reciprocal, for allocating costs of service or support departments to operating or production departments are described and illustrated Two other methods for allocating common costs are also presented—stand-alone and incremental Importantly, the text covers the why and how of cost allocation between business segments

Contract disputes that arise over the allocation of costs are also addressed

Allocation is a pervasive concept and its application to revenues is included The bundling of multiple products to sell for a single price requires allocation of that price if a manager is to be held responsible for individual product revenues or profits or if bonuses are calculated on individual products The two methods illustrated for revenue allocation are methods used for allocation of costs—stand-alone method and incremental method Examples are used to explain details of each method

CHAPTER OUTLINE

TEACHING TIP: In Chapter 4, the basic method by which costs are allocated was introduced as primary

to a normal costing system In Chapter 8, the basic is changed to incorporate standards

Allocation amount = Allocation rate x Usage of cost allocation base

The following portion of the outline addresses the elements of this formula To allocate or not to allocate

a particular cost is the first question Other questions follow: how to group costs to be allocated, what to use as the cost-allocation base, should cost behavior (fixed and variable) be incorporated into the

allocation process, should the costs and cost-allocation levels used for the rate be budgeted ones or actual amounts, should the usage amount by which the rate is multiplied be budgeted or actual amounts, and what specific method to use—direct to primary unit, step-down through other groupings on way to primary unit, or reciprocal of secondary groups sharing with each other to find amount for primary group?

I Allocation formula issues

Learning Objective 1:

Differentiate the single-rate from the dual-rate cost-allocation method

A Different methods of allocating fixed and variable costs: one rate for mixed cost or two rates using one for fixed costs and one for variable costs

1 Single-rate cost-allocation method

a Pools all costs regardless of behavior in a cost pool

b Allocates to cost object using same rate per unit of single allocation base

c Cost to implement is low—avoids often expensive analysis to classify individual cost items into fixed and variable categories

d Often leads to decisions in own best interests of individual manager but not best interest for organization as a whole

2 Dual-rate cost-allocation method

a Pools cost into two separate cost pools according to behavior—fixed and variable

b Allocates to cost object with each cost pool using different cost-allocation base

c Signals to managers how costs behave differently

d Provides better information for making decisions (should be method used)

Do multiple choice 1 Assign Exercise 15-16.

Learning Objective 2:

Understand how the uncertainty managers face is affected by the choice between budgeted and actual cost-allocation rates

B Different rates to use for allocation: budgeted cost rates or actual cost rates

1 Budgeted cost rates

a Rates known in advance reduce uncertainty

b Users can determine amount of service to request as rates known in advance

c Managers motivated to improve efficiency bear risk of unfavorable cost variances

2 Actual cost rates

a Rates not known until end of period

b Amounts allocated fluctuate so users bear the risk

C Different usage quantities of fixed costs in allocating: budgeted or actual quantities [Exhibit 15-1]

1 Budgeted quantity usage

a Helps in planning, especially for long run

b Unaffected by variations in other divisions

c Requires realistic estimates, accurate forecasts

2 Actual quantity usage—not known until end of period

3 Practical capacity supplied

a Each division only charges for actual use

b Variations in actual use in one division do not affect costs allocated to other divisions

c Costs of unused capacity are highlighted and not allocated to user divisions

Do multiple choice 2 Assign Exercises 15-17 and 15-18 and Problems 15-28 and15-30.

II Allocation methods to use for reciprocal relationships

A Distinguishing between types of departments within an organization

1 Operating department or production department: directly adds value to a product or

service

2 Support department or service department

a Assists other internal departments in the company

b Creates special allocation problems when providing reciprocal support to each other as well as operating departments

c Results in more accurate costs of products, services, and customers when more accurate

in support department allocations [Exhibit 15-2]

Learning Objective 3:

Allocate support department costs using the direct, step-down, and reciprocal methods

B Distinguishing among specific allocation methods for allocating support costs

1 Direct allocation method [Exhibit 15-3]

a Most widely used method of allocating support department costs

b Allocates each support department’s costs directly to operating departments

c Benefit of simplicity

d Disadvantage is failure to recognize reciprocal services provided among support

departments

2 Step-down allocation method (also called sequential allocation method) [Exhibit 15-4]

a Allows for partial recognition of services rendered by support departments to other support departments

b Requires support departments to be ranked (sequenced) in the order of the allocation

c Often uses department with highest percentage of its total services to other service departments to start allocation sequence, with next-highest following, etc

d Does not recognize total services that support departments provide each other

3 Reciprocal allocation method [Exhibit 15-5]

a Allocates costs by explicitly including mutual services provided among all support departments

b Conceptually most precise method because considers mutual services provided among all support departments

c Highlights complete reciprocated costs of support departments and how those costs differ from budgeted or actual costs of departments—key input for decisions about outsourcing

d Requires three steps: [Exhibit 15-6]

i Step 1: Express support department costs and support department reciprocal relationships in the form of linear equations

ii Step 2: Solve the set of linear equations to obtain the complete reciprocated costs of

each support department

iii Step 3: Allocate the complete reciprocated costs of each support department to

all other departments (both support departments and operating departments) on the basis of the usage percentages (based on total units of service provided to all departments)

[Surveys of Company Practice]

TEACHING TIP: Use a sentence in words about the costs of a support department before developing the equation From the text example—the full cost of the Plant Maintenance support department is or equals

$600,000 plus costs used by Plant Maintenance that were supplied by Information Systems (The terms of used by [use column] and supplied by [use row] are helpful when using the format of exercises and problems in the text.) Substituting mathematical symbols in place of the words will develop the equation

Do multiple choice 3, 4, and 5 Assign Exercises 19 (20) and 21 (22) and Problems 15-31,

15-32, and 15-33.

III Methods of allocating common costs

A Common cost: cost of operating a facility, activity, or like cost object that is shared by two or

more users

Learning Objective 4:

Allocate common costs using either the stand-alone or incremental method

B Methods for allocating

1 Stand-alone cost-allocation method

a Uses information pertaining to each user of a cost object as a separate entity to determine the cost-allocation weights

b Emphasizes fairness or equity criterion because each user bears a proportionate share of total costs in relation to individual stand-alone costs

2 Incremental cost-allocation method

a Ranks individual users of a cost object in order of users most responsible for the common costs, then uses this ranking to allocate costs among users

b Disputes as to which is incremental user

3 A caution—chosen method of allocation should be acceptable to each user

Do multiple choice 6 Assign Exercises 15-23 and 15-24.

Learning Objective 5:

Explain the importance of explicit agreement between contracting parties when reimbursement is based

on costs incurred

IV Cost allocation and Contracts

A Reduce disputes by making “rules of the game” explicit and in writing at time of contract signing

1 Definition of cost items allowed

2 Definition of terms used

3 Permissible cost-allocation bases

4 Handling of accounting for differences between budgeted and actual costs

B Complex interplay of political considerations and accounting principles

1 Reimbursement: contractor paid set price without analysis of actual contract cost data

a Competitive bidding

b Adequate price competition

c Established catalog with prices quoted for items sold in substantial quantities to general public

2 Reimbursement: contractor paid after analysis of actual contract cost data: cost-plus contract

a Compliance with Cost Accounting Standards Board: for uniformity and consistency in

regard to measurement, assignment, and allocation of costs

b Terms such as “fairness” and “equity” often used along with cause and effect and benefits received

C Fairness of pricing [Concepts in Action]

1 Costs-plus-fixed-fee contracts

a Initiating party assumes major share of risk of potentially high costs of completing contract

b Use of allowable costs: cost contract parties agree to include in costs to be reimbursed

Do multiple choice 7 Assign Problem 15-35

TEACHING TIP: In calculating proportions or weights to use in allocating, it is sometimes helpful to remind students that order is not important in multiplication and division The amount of cost allocated will be the same whether one uses the sequence

(individual amount/total amount) (proportion) x cost to be allocated = allocated cost or

(individual amount x cost to be allocated) / total amount = allocated cost or

individual amount x (cost to be allocated/total amount) (rate) = allocated cost.

I Revenues

A Essential to profit

B Important to managers

1 Revenue planning

2 Revenue analysis

V Revenue allocation

Learning Objective 6:

Understand how bundling of products gives rise to revenue-allocation issues

A Revenue allocation and bundled products

1 Definitions

a Revenue allocation: assigning of revenues that are related, but cannot be traced in an

economically feasible way to revenue object

b Revenue object: anything for which a separate measurement of revenue is desired

c Bundled product: package of two or more products or services, sold for a single price,

but individual components of the bundle may be sold as separate items at their “stand-alone” prices

2 Issues

a Single price for bundled product typically less than sum of prices of individual products sold separately

b Separate measurement (allocation) of revenue by product if manager responsible for individual product revenues or profits

Do multiple choice 8 Assignment follows L O 8

Learning Objective 7:

Allocate the revenues of a bundled package to the individual products in that package

B Revenue allocation methods

1 Stand-alone revenue-allocation method

a Description: uses product-specific information on products in the bundle as weights for allocating bundled revenues to individual products

b Weights

i Selling prices

ii Unit costs iii Physical units in which each unit has the same weight

iv Stand-alone product revenues

c Advantages

i Revenue as weight—selling price and stand-alone product revenues

 Use of benefits-received criterion (revenue as benefit)

 More weight to product that generates more revenue and drives sale of bundled products

ii Physical units as weight

 Ease of use

 Less limitations than other methods if costs difficult to calculate or selling prices unstable

2 Incremental revenue allocation method

a Description: ranks individual products in a bundle according to criteria determined by management, then uses ranking to allocate the bundled revenues to the individual products

b Ranking

i Terms: first-ranked is primary product, second-ranked is first incremental product, third-ranked is second incremental product

ii Criterion

 Survey of customers as to relative importance of individual products in decision

to purchase bundled products

 Data on recent stand-alone performance of the individual products in the bundle

 Top managers use their knowledge or intuition to decide the rankings iii Comparison to stand-alone method: stand-alone method less likely to cause acrimonious debates among product managers

c Management judgment not explicitly based on specific formula

Do multiple choice 9 and 10 Assign Exercise 15-25 and Problem 15-34

CHAPTER QUIZ SOLUTIONS: 1.d 2.c 3.a 4.c 5.d 6.b 7.b 8.a 9.b 10.a

CHAPTER QUIZ

1 The use of a dual-rate cost-allocation method recognizes

a the improvements in technology allowing for use of multiple cost pools

b the need to use both budgeted and actual cost rates when allocating

c the need to use both budgeted and actual usage of quantities when allocating

d the behavior aspect of costs

2 Managers are affected by risks they have to take and would prefer to use

a actual rates for cost allocation because the rates are calculated from real amounts

b actual rates for cost allocation because actual rates are easier to justify to users

c budgeted rates for cost allocation because the rates are known in advance

d budgeted rates for cost allocation because any variances are transferred to users

The following data apply to questions 3–5

Billy Stone, Inc., budgets the following amounts for its Buildings & Grounds and Computer Services Departments in servicing each other and the two manufacturing divisions of Signs and Mailers:

Used By Supplied By Building & Grounds Computer Services Signs Mailers

The actual results for the time period were as follows:

Used By Supplied By Building & Grounds Computer Services Signs Mailers

Actual cost data for each department are:

Fixed Variable

3 Total fixed costs allocated from Buildings & Grounds to the Signs Department, using the preferred allocation basis, by the direct allocation method are

4 Total variable costs allocated from Computer Services to Mailers Department, using the preferred allocation basis, by the step-down allocation method (begin with Building & Grounds) are

5 The equation to determine the total variable costs of Computer Services using the preferred allocation basis, for the reciprocal allocation method is

a CS = $21,000 + 0.25 B&G c CS = $21,000 + 0.15 B&G.

b CS = $21,000 + 0.20 B&G d CS = $21,000 + 0.10 B&G

6 If a cost is incurred for more than one user, that cost is considered a(n)

a homogeneous cost

b common cost

c stand-alone cost

d incremental cost

7 Which of the following is often the most basic cause of contract disputes?

a allowable costs

b cost-allocation issues

c use of common costs

d writing into the contract “rules of the game”

8 Bundling of products creates the need for revenue allocation for each of the following except when

a selling prices for the bundle are set to recoup the stand-alone prices of each product in the bundle

b the manager is responsible for profitability on a product-by-product basis

c the manager’s bonus is based upon product profitability

d persons involved with product development are compensated by percentage of revenues realized

Use the following information for questions 9 and 10.

Trio Company sells three products, Do, Ra, and Mi, for prices of $8, $7, and $5, respectively They also offer combinations of the products for reduced overall prices The following packages are available: (1) a package containing Do and Ra sells for $13.50, (2) a package of Do and Mi sells for $11.50, (3) a

package containing Ra and Mi sells for $10.50, and (4) a package of all three products, Do, Ra, and Mi, sells for $17.00

9 If Trio Company uses the stand-alone method (based on selling prices) to allocate revenues to products, the amount of revenues to be allocated to Do from a package of all three products, as described in (4) above, sold would be

10 If Trio Company uses the incremental-revenues allocation method and has designated Ra as the primary product, the amount of revenues from a bundled package of all three products to be allocated

to Ra would be